Sunday, February 28, 2016

One or more rate hikes by the Federal Reserve in 2016 remains a real possibility. Why would the Fed consider such a policy action given the recent collapse in inflation expectations?

Over the past couple of months many analysts and the futures markets have assigned a rather high probability to the so-called "one and done" - no change in policy in 2016. Indeed, here is what we've heard recently from St. Louis Fed President James Bullard:

Reuters: - The Federal Reserve must act to stop inflation expectations from getting too low, St. Louis Fed President James Bullard said on Wednesday, reiterating his concerns about continuing to raise interest rates.

The U.S. central bank cannot let low inflation expectations "get out of hand," he told a dinner of bond traders here, adding he "can't stomach" currently low readings. "It's just that they've fallen so far that it's got to be a concern."

However a number of researches have suggested that with a relatively stable core inflation in the United States, oil prices would need to collapse to levels that are neither consistent with today's forward curve nor sustainable. Therefore, these studies argue, the current market-based inflation expectations are simply irrational.

3. As an example of where some of this inflation is coming from, shown below is the medical care CPI. It has been subdued last year but is now is waking up again.

Source: St. Louis Fed

Additionally, the cost of shelter in the US is now rising at over 3% per year, with the rate continuing to increase. Sadly, this is materially higher than the national wage growth rate, putting pressure on Americans with low-paying jobs.

Source: St. Louis Fed

4. We also see the so-called "sticky" CPI (the less volatile components of the CPI) reaching 2.5% - the highest since 2009.

Source: St. Louis Fed

Some analysts (RBS for example) have been suggesting that deflation is about to sweep the global economy, pulling in the US along the way. For now however there is simply no evidence of deflationary pressures in the world's largest economy.

Other indicators released last week could add to the ammunition of the more hawkish FOMC members.

1. US consumer spending was stronger than expected last month. Alas, some of this increase was driven by higher spending on healthcare, but it's an important data point nevertheless.

Source: St. Louis Fed

2. While this next item is more symbolic in nature, it's an important milestone nevertheless. US house prices (at least according to the government's index) are finally above the pre-recession peak.

Source: St. Louis Fed

The futures markets are starting to react to all these reports, with the Fed Funds futures falling on Friday (lower futures prices imply higher rates).

Source: barchart

In the coming months the Fed will be closely watching two key economic measures as the Committee contemplates further rate hikes.

1. Any indications of acceleration in wage growth will get the Fed going again. The high-frequency Gallup jobs indicator suggests that US labor markets remain stable, but material improvements in wage growth have been elusive.

2. The recent market turmoil has ignited concerns about tight credit conditions. The Fed's surveys suggest stricter underwriting standards in business lending while other indicators point to weakness in credit availability for middle-market and smaller businesses. And of course credit spreads have risen sharply, especially for the more leveraged firms. However the overall corporate loan growth remains close to 11% per year - for now.

Source: St. Louis Fed

Some suggest that raising rates in the current environment is nothing short of insanity. Given the monetary easing by the ECB, the BOJ, etc. (as rates move deeper into negative territory) or the dovish stance by the BOC, the BOE, and others, the US dollar is bound to resume its rally, causing further damage to the US economy. In fact the latest PMI measures, (from Markit as well as ISM) suggest that the US economic activity has already slowed sharply in the first quarter. Nevertheless, given the Fed's focus on some of the indicators discussed above, rate hikes in 2016 are now back on the table.

Saturday, February 20, 2016

The worldwide collapse in commodity prices is now working its way through the financial markets in Canada. Canada is just now experiencing fundamental changes in the financial community, the sector better known as F.I.RE ( Finance, Insurance and Real Estate ) . This sector accounts for approximately 20% of national income and employs more than one million workers, providing a broad spectrum of services to all parts of the economy. One subsector, in particular, the investment or securities industry has been hardest hit of late.. This blog examines the adjustments in the securities industry; future blogs will look at the banks, life insurance and real estate markets.

To appreciate just how much the F.I.R.E. industry has suffered , we turn to the TSX and its major components as listed in Table 1. In the period 2007 to 2014, the Canadian stock market as a whole fell by 4%. However, the financial sector as a whole performed relatively well increasing by some 21%, largely on the back of the commercial banks, supported by good loan growth and capital market activities. However, within the investment community, independent investment houses have taken quite a beating. The two publicly traded companies, GMP and Canaccord, have seen their corporate value been truly been decimated ( a price drop of 80%) . Finally, the lifecos have yet to recover from the 2008 crisis and continue to see their stocks trade well below pre-crisis levels ( as much as 60% lower).

These trials and tribulations continued over the past 12 months as all segments of the FIRE industry have seen values drop further. Along with the decline of the TSX60 , the finance sector is off a further 19% , partly in concert with the decline in world stock markets, but more reflective in the fall in oil and other commodity prices. Even the much vaulted Canadian banks are feeling the impact of losses in the energy sector. REITs which have been a haven for investors are now in decline( off by 18%). And, of course, the investment dealers continue their slide as they suffer under the weight of several factors unique to the industry. We now turn our attention to those issues.

Investment Industry Under Pressure
The securities industry, and in particular, the independent dealers are crucial to a well-functioning capital market. The big six banks have swallowed up major investment dealers in the 1990s; they use these investment firms to continue to fund large publicly traded companies . Independents, on the other hand, supply funds to small and medium size industries, especially in the resource and tech sectors. Often these companies are deemed too risky to qualify for conventional bank lending . Thus, they have filled an important gap in the capital markets and their current weakened position will have an adverse impact on the effectiveness of the Canada's capital markets to promote economic growth.

These are not happy days for the investment dealers. Revenues are weak, costs are escalating and the nature of their business is undergoing structural changes.
The number of firms have declined as part of a wider consolidation as profitability is squeezed throughout the industry. Chart 1 illustrates the change in revenue sources between 2007 and 2015.

With the exception of fixed income trading, all categories of revenues have declined, especially equity trading commissions and investment banking fees - two stalwarts of the past. Table 2 summarizes the main financial operating results of the past 12 months. The two notable impacts have been the reduction in revenues and the rise in the cost of operations. Overall, profitability is dismal compared to prior years--- 4.6% rate of return in an industry accustomed to rates of 20% or more. As a result, shareholders' equity has taken a beating, forcing weak companies out of business and others to shore up capital to meet regulatory requirements. What is behind this poor performance?

A series of radical changes has hit the industry simultaneously :

the collapse of the commodity markets. Many of the independent firms specialize in financing medium size resource/extraction enterprises; the collapse resulted in very few investment banking opportunities, shrinking that revenue segment of the industry significantly,

technological driven price wars. There has been a relentless move towards lower commission prices and electronic trading, contributing to the fall off in revenues.

compliance and regulatory changes. Ian Russell the President of the Investment Industry Association of Canada (IIAC), estimates these costs have risen by 7% in 2015, on top of a 6% rise in 2014. He believes " the relentless rise in operating costs will squeeze profitably" in 2016.

The industry features many small independent, boutique -size firms that no longer can compete for capital; the bulk of the firms are capitalized at $10 million or less, precluding them from participating in larger financing deals. Russell expects a further consolidation as firms either merge and/or shut down.

The IIAC recently conducted a survey of its members on the outlook for the industry.
The majority of members remain pessimistic , citing the following:

Rising costs owing to higher compliance and new technology requirements; both add to staff and to total operating costs;

Weak economic conditions as Canada adjusts to the new realty in commodity prices and the slowdown in world trade;

Consolidation and restructuring. Over the past 4 years, 25% of the industry has left the business through mergers and amalgamations , closing operations entirely or transferring business out to competitors.

It is no wonder that the majority of the industry leaders expect further contraction in the coming years as part of shake out in the industry . It may turn out, in the longer run, that the Canadian capital market will benefit from this re-structuring and may be stronger as a result. However, at present, the principal concern is that this consolidation will negatively affect the viability of the industry to participate in the financing of future economic growth.

Sunday, February 14, 2016

In January 2016, global foreign reserves (FX) continued their decline after an absolute peak in June 2014, declining significantly in distressed emerging countries and some notable oil-producing economies (see Figure 1).

Figure 1.

China and Saudi Arabia, the leading owners of foreign reserves outside the OECD circle, both experienced an outflow greater than 5% of their outstanding reserves in less than 6 months (see Figure 2). A common factor explains these drawdowns: both the countries are struggling to defend their currency peg to the Dollar. The pressures on the exchange rates can be traced back to three intertwined drivers: the (still to come) interest rate hike cycle in the US, the low oil price and the China slow growth. While the “US rate hike tantrum” can be considered as a symmetrical shock for all the worlds currency different from the Dollar, the other factors have hit the distressed countries in differentiated ways.

From the Chinese side, the worsening growth’s prospects and strong capital outflows are forcing the People bank of China (PBOC) to employ its FX reserves with the aim to manage a controlled, but unavoidable, devaluation. Meanwhile, the persistent slump oil price (that depends a lot from China’s slowdown) have decimated the revenues of the Saudis. Since these money flows count for over 80% of the State budget, the government is now tapping the debt market at the astronomical pace of 16% of GDP at year to compensate for the loss. This dramatic reversal in the health of public finances obviously put pressure on the fixed peg with the dollar.

Figure 2.

Indeed, as it emerges from the comparative analysis of Figures 1,2, both the declines for China and Saudi Arabia took off and reinforced during the prolonged crash of the oil price. The same phenomenon can be appreciated on a global scale (Figure 3): world FX reserves peaked and declined in sync with the oil price. Net of “value effects” that depend from the changing composition of the reserves, falling oil revenues and GDP slowdown in major exporting countries remain significant explaining factors.

Figure 3.

A central bank’s monetary policy stance is often captured better by changes in their overall balance sheet that comprehend both FX reserve movements than other conventional monetary policy actions, e.g. reserve rates cuts or repo operations. Broad-based indicators such as monthly variation in central bank total assets are more informative of the aggregate global value of central bank liquidity.

Figure 4 illustrates the historical movements of central bank assets in the past 6 six years: Fed QE 2 and 3 are clearly identified by the navy bars, and Shinzo Abe’s QQE (Qualitative and Quantitative Easing) is captured by the red bars. The first expansion in ECB balance sheet of 2011-2012 (light blue bars) is attributable to the two big LTROs, and the subsequent contraction is due to LTROs repayment by European banks. In 2015 the Draghi QE (the Public Sector Purchase Programme or PSPP) has taken off and has pushed the ECB net liquidity flows in positive territory. It’s interesting also to notice the expansionary pulses of the Swiss National Bank (SNB) monetary policy, aimed at maintaining the peg of the Swiss Franc with the Euro in 2012-2014. The last frantic efforts ended suddenly in January 2015, when the ballooning the of SNB balance sheet and the accelerating expansion of the monetary base forced the SNB to readjust the CHF /EUR exchange rate.

Figure 4.

Declining FX reserves caused concern in global markets following the decision of the PBOC to abandon the Renminbi fixed exchange rate with the Dollar. Struggling against mounting pressures on the Renminbi / Dollar exchange rate, the People Bank of China flooded the market with US Treasuries, causing a spike in yields and turmoil in global equities. Since selling foreign assets acts as a counterbalance to Quantitative Easing, some market participants applied the phrase Global Quantitative Tightening (QT). In other terms, by liquidating US Treasuries and other OECD government and private bonds, the central banks of emerging countries resupply the market of securities, balancing the purchase made by their OECD counterparts. This QT action by emerging and oil-exporting countries would therefore drain liquidity from the market, neutralizing expansionary policies of Eurozone and Japan. In this perspective the $ 130 billion of fresh money injected monthly via asset purchases by the OECD central banks would be offset by their emerging counterparts.

Our indicator of central banks' global liquidity seems to support this reconstruction. In 2015, EM central bank sales of foreign assets reduced central banks’ liquidity flows (Figure 5). The effect began in July and peaked in September during the Renminbi crisis.

Figure 5.

The concept of global QT gained traction in September 2015 as the negative correlation between global equities and foreign reserves increased. The Fed’s decision to maintain interest rates relieved the downward pressures on Renminbi and the interest in QT quickly waned.

There have been reasoned opinions on the economic theory behind global QT. More than one analyst correctly observed that a USD asset sales by foreign central banks will not drain liquidity and counteract Fed monetary policy because these assets simply change hands and do not disappear. Changing ownership does not preclude reinvestment in the US banking system, which limits the sale’s tightening effect. Moreover, as already pointed out, changes in foreign reserves may not reflect a central bank’s attitude towards monetary policy since they do not account that other conventional monetary policy actions on banks’ reserves or interest rates can dominate changes of foreign reserves.

In the last quarter of 2015, the correlation between global stock indices and central banks net liquidity is again up (see Figure 6).

Figure 6.

Remarkably, temporary positive net flows of central banks liquidity are associated with the markets rebound of October 2015.

We are obviously aware that correlation does not necessarily mean causation. From a broader perspective, it's more than reasonable that the same three cyclical drivers that explain drawdowns in foreign reserves (China’s slowdown, the US rate hike cycle, and collapsing oil prices) are also affecting equity markets.

We should acknowledge these changes in foreign reserves as a reaction by emerging countries central banks to these three primary factors. Nevertheless, their impact on net liquidity, which may mitigate monetary expansion by the ECB and BoJ should be worthy of further investigation.

Sunday, February 7, 2016

Some people say that gold is dead. They point to deflationary pressures and a bear market that started back in September of 2011. The bulls have been wrong for years; however, that may be about to change…

At present, there are multiple reasons to consider gold:

Sentiment is very negative and almost everyone is underweight

Supply & demand fundamentals are positive

Chinese demand continues to rise

Gold is a means to portfolio diversification

The main risks to prices are overblown

In the next sections, we will examine the bull case for gold and the risks facing it. In conclusion, we will try to answer the following question: Is this the beginning of a new golden age?

Sentiment & Positioning

In the latest Barron’s Big Money Poll, only 3% of respondents thought that gold was the most attractive asset class. Moreover, 71% were bearish on the yellow metal. Volume traded in $GLD (the SPDR Gold Trust ETF) has come down dramatically, which indicates a lack of interest in gold bullion. Volume traded in $GDX (miners) and $GDXJ (junior miners) has been increasing; however, interest in “gold mining stocks” has been falling since mid-2011. This suggests that traders are trying to catch the falling knife, even though investors are not convinced that gold is undervalued.

In terms of positioning, market participants are heavily underweight materials and commodity stocks. Is this a contrarian buying opportunity? It could be. Especially because the current bear market is getting old. The following table shows the 5 most recent bull and bear markets:

Gold prices fell by 44% over the 52 months from September of 2011 to January 7th of 2016. Those numbers match the median length and average cumulative return of the previous 4 bear markets. Gold may continue to fall from here; however, we are probably closer to the end of the bear market than to the beginning…

Supply & Demand

~46% of gold production is FCF negative at current prices. In other words, $1100 is not the equilibrium price. If we stay at these levels then supply will likely decline. Analysts at Credit Suisse ($CS) are projecting a deficit to begin in 2016. They expect that mine supply will fall by 11.5% from 2015 to 2018:

Even at higher prices, gold miners will be unable to replace all of their depleting reserves. Also, it will be very expensive for them to bring new projects online. Lastly, it is important to note that major gold discoveries have become scarce. These trends are negative for supply and positive for prices.

On the demand side, Asia and Europe should continue to support the market. Total bar and coin demand (in tonnes) increased 33% YoY from Q3’14 to Q3’15. Furthermore, consumer demand was up across the board, with exceptionally big numbers in the US. According to the World Gold Council (WGC), “coin sales by the US mint during the quarter were on par with that of Q4 2008.” Another key source of demand is central banks. They have continued to buy as they look to diversify their reserve assets. This speaks to gold’s utility as a portfolio diversifier. Total demand has been falling; however, the quarterly numbers suggest it could be stabilizing. Going forward, consumer demand is likely to offset ETF outflows.

India & China are the main drivers of demand for gold. In 2014, they accounted for ~1710 tonnes of demand. To put that in perspective, 1700 tonnes = 53% of total consumer demand:

Gold is a big part of both India’s and China’s culture. As such, it is likely that demand will remain strong.

China’s Gold Market

There is an interesting divergence taking place in the physical gold market. China’s demand numbers, as measured by withdrawals from the Shanghai Gold Exchange (SGE) are much higher than those reported by the World Gold Council (WGC). SGE withdrawals exceeded the WGC’s demand estimates by 3,193 tonnes from 2007 to 2014.

The following passage is from Bullion Star’s Koos Jansen helps to explain the discrepancy. “The difference was labeled as net investment (in the CGA Gold Yearbook 2013 at 1,022.44 tonnes), which is calculated by the China Gold Association (CGA) as a residual between what is withdrawn from the SGE vaults and gold sold at retail level (jewelry shops and banks). The WGC doesn’t count net investment on its demand balance, but only measures what is being sold at retail level. Net investment, which roughly equals the difference, can only be caused by direct purchases from individual and institutional customers at the SGE that withdraw their metal.”

In China, gold imports must pass through the SGE before entering the market place. In addition, bullion exports are prohibited. It follows that Imports + Mine Supply + Scrap = Total Supply = SGE Withdrawals. Said another way, SGE withdrawals are equivalent to domestic wholesale demand. The preceding formula is supported by reports from the CGA and the SGE. For example, the SGE reported that 2197 tonnes were withdrawn its vaults in 2013. That is the same number that the CGA reported for total demand in 2013. More evidence comes from the SGE’s chairman, Xu Luode, who said the following in 2014:

The main conclusion is that the SGE’s measure of Chinese gold demand is much higher than the WGC’s. If the SGE’s number are correct then China is absorbing most of the world’s mine supply. Gold withdrawals from the SGE for 2015 amounted to 2596 tonnes, or 91% of world gold production:

Diversification & Protection

Gold has a negative correlation with US stocks during expansions. More importantly, its correlation with both global and US stocks is more negative during contractions:

As a result, gold tends to rise when stocks fall, which is good for portfolio diversification.

Gold is also an FX hedge for foreign investors. In 2015, it performed relatively well in non-dollar currencies such as the Brazilian Real, the Russian Ruble, the Chinese Yuan and the Canadian dollar. This is important because non-US countries are the main consumers of gold.

Gold can also protect us against a rising cost of living because it tends to hold its value over time. If you look at the CPI then inflation seems relatively low. That said, the CPI is a utility index, not a measure of the cost of living. Most people would agree that cost of living is rising. For example, education and medical care costs have been outpacing the CPI for years.

Risks

Gold’s main threats are…

1) A stronger USD

Typically, the US dollar index and gold are negatively correlated. Said differently, when the dollar index does up, gold goes down. Even so, last year, the US dollar (USD) influenced gold prices more than it usually does. In 2015, the correlation between the two was -0.50 in 2015, much higher than -0.36, which is the 30-year average. Going forward, it’s likely that the correlation between gold and the USD will revert back to normal.

Even if rates do increase, gold may perform well. According to Sundial Capital Research, gold actually does quite well in rising rate environments. Gold prices increased by an average of 25.2% in each of the rising rate environments from Dec31’76 to Dec27’13. The median gain was 5.2%, which is much less impressive but still positive. Low rates are probably better for gold than high ones. That said, it may show good returns either way.

3) Leverage

In the US, the paper gold market is much bigger than the physical one is. In other words, many contracts are traded but not much gold changes hands. The level of gold dilution has reached unprecedented levels. In a recent blog post, zerohedge showed that there are 40 million ounces worth of open interest but only 74 thousand ounces of registered gold at the Comex. This works out to a gold cover ratio (open interest/registered gold) of 542! The takeaway point is that the amount of gold that is traded is much greater than the amount that actually exists.

The downside risk is that supply in the futures market overshadows demand in the physical market, thereby weighing on prices. Still, there is an upside risk. If demand for physical gold remains strong and inventories continue to fall then then the Comex may run out of supply. If that happens then gold prices will rise as market participants start to question the divergence between the paper and physical markets.

Conclusion

Gold should be considered as a contra buy…

It is hated

Its fundamentals are improving

Demand from the east is robust

It is negatively correlated with stocks

The benefits outweigh the risks

Gold is massively under owned. If sentiment improves then it could easily outperform other asset classes in 2016…

What does the oil price collapse mean for Canada? A simple question with an the answer that is anything but simple. As the Governor of the Bank of Canada (BoC), stated the "oil price shock is complex because it sets in motion several forces " that will alter the path of Canada's economic future. The Governor goes on to argue that "it may take up to three years for the full
economic impact to be felt, and even longer for all of the structural
adjustments to take place.” Just what are the structural and time factors that we need to understand as we adjust to the new environment of lower commodity prices?

We start out by considering the structure of the Canadian economy. This will help identify how the various sectors of the economy will be impacted in the future. Broadly speaking, Canada is a service-based economy (70% of output) and only selectively a goods-producing country (30%). The largest component of services is the finance, insurance and real estate (FIRE) which now comprises about 20% of national income. These industries surpass the contribution of mining, oil/gas and energy distribution (17%) and manufacturing (10%). The strength of the services sector blunts much of the pain of falling oil prices.

Immediate Impacts of the Oil Price Collapse

Taking a snapshot of what has happened in the past 12 months, we note in Table 2 that:

Oil prices declined by 40% in 2015, the Canadian dollar sank another 20%, on top of a 20% drop in 2014. The currency bore the greatest adjustment ;

The currency devaluation did not , however, affect trade picture. The current account balance remained deep in negative territory;

National output clocked in at a dismal rate of less than 1%;

The rate of inflation accelerated due to the falling currency and its impact on basic imports, especially food products; and,

Unemployment remained steady at around 7% for the year 2015.

Viewed from a national perspective, the oil price collapse has had a marginal impact on the economy during 2015. The burden of adjustment has fallen almost exclusively on the exchange rate; most other indicators have not change appreciably . However, below the surface, we are seeing evidence of the deteriorating conditions.

Within the resource sector, employment declined by 9-12% and incomes have fallen as much as 15-16% ( Table 3). More importantly for the future, the cumulative decline in business investment in this period was 8% and ,in the case of engineering structures, (related to resource development) the decline was 13%.

The dominance of the service sector and other non-energy goods producing industries allows for national income and jobs to remain in positive territory. In other words, the impact of falling oil prices has, temporarily, been confined to the resource sector and to its geographic centre. The emphasis is on temporarily since there are longer term consequences facing the country as it comes to terms with the worldwide deflation in commodity prices.

Longer Run Adjustments

Research staff at the Bank assessed the path of economic growth over the next 3-5 years assuming that commodity prices remain at current levels.(1) Theirs is an attempt to map out the path the economy would likely take ,given the new reality of low commodity prices..

The analysis sets a control" scenario in which commodity prices remain at mid-2014 level. Results are then measured against the "control" scenario. Thus, an outcome that is “lower” implies it is lower than in the "control "case, not that it is lower in absolute terms. By the end of 2020 we can expect that:

capital investment in the commodities sector to be lower , reducing the economy's buildup of productive capacity; this results in a lower potential GDP growth rate;

the share of commodities in the economy will decline toward the pre-boom levels of 2002;

exports as a share of national income will be lower due to the decrease in the terms of trade;

domestically, households will gradually adjust to lower wealth and incomes; and

personal consumption will be lower, reflecting the reduction in incomes.

These outcomes strongly indicate that it will take much longer to absorb the current excess capacity. Investment, consumption and overall growth will be lower than had the oil prices not collapsed . Simply put, the road to recovery has now become longer and steeper.